Baltimore city is among many suing big banks over allegations of rate-rigging

For small investors, this could be the scandal that finally breaks their trust

July 09, 2012|By Eileen Ambrose, The Baltimore Sun

You're likely part of the largest financial scandal in the world today if you have an adjustable-rate mortgage or a private student loan.

Or live in Baltimore.

The city is suing more than a dozen major banks, claiming the institutions conspired to manipulate the London Interbank Offered Rate, or Libor. This is a benchmark used to set interest rates on variable-rate credit cards and mortgages plus trillions of dollars' worth of financial instruments, including some purchased by the city of Baltimore.

Barclays is one of the banks being sued by Baltimore. Late last month, the bank agreed to pay more than $450 million to settle charges by American and British regulators that it attempted to rig Libor over several years. Its CEO and chief operating officer resigned. Now other big banks are under investigation by a who's who list of regulators and law enforcement agencies around the world.

Usually in financial scandals, consumers get burned. But if allegations in this one are true, the rate-rigging actually worked in their favor. That's because banks are being accused of manipulating Libor so it would be lower than it should have been, which means borrowers would end up paying less in interest.

But consumers may be hurt in other ways. If, say, Baltimore and other municipalities earned less on their investments than they should have, the cities might be forced to raise taxes or cut services to make up the difference.

And if this scandal turns out to be another case of banks behaving badly, it also could be enough to kill what little trust small investors still have in the markets.

"People are so cynical about financial markets," says Yuval Bar-Or, an adjunct professor at the Johns Hopkins Carey Business School and author of "Play to Prosper: The Small Investor's Survival Guide." "There is yet another huge scandal that's rocking the highest echelons. … It only makes [investors] have less and less faith in the financial markets."

Bar-Or worries that if small investors conclude that the whole system is rigged, they might avoid the stock market. And if that happens, he says, their nest eggs won't be able to keep up with inflation.

Until now, most people likely never gave Libor a thought. According to the U.S. Commodity Futures Trading Commission, Libor is tied to more than $900 trillion worth of loans, swaps and futures contracts.

Amazingly, as critical as Libor is to the world markets, it's basically generated using the honor system. A panel of banks report daily to the British Bankers Association — a trade group, not a regulator — what rate they would expect to pay if they borrowed from another bank. Some of the highest and lowest rates are thrown out, and the rest are averaged. The resulting rate is published daily.

Baltimore's lawsuit involves the city's purchase of hundreds of millions of dollars in interest-rate swaps — an instrument used to protect the buyer from fluctuating rates — linked to Libor.

The city sued the banks last year in federal court in New York, and its lawsuit was consolidated with those filed by others, including pensions funds and Charles Schwab & Co. The banks named in the suit include such familiar names as Bank of America, JP Morgan Chase, Citibank, HSBC Bank, Deutsche Bank and Credit Suisse.

In lending, the riskier a borrower, the higher the interest rate that borrower must pay. Baltimore and other plaintiffs claim that the banks under-reported rates to make themselves look stronger in the aftermath of the 2007 financial crisis.

The city also claims that by keeping rates artificially low, the banks paid less interest to investors buying financial instruments tied to Libor.

Lawyers for the city say it's unclear how much in interest Baltimore lost.

"It is a significant amount of money," says City Solicitor George Nilson, who estimates the loss could range from the "high hundreds of thousands into the millions."

Just think of how many recreation centers, fire companies or school renovations could be financed with that money.

Late last month, the banks asked the court to throw out the Baltimore case, saying it had no facts to back up claims that the banks colluded to suppress interest rates.

If the banks were trying to hide financial weakness as Baltimore claims, they wouldn't have shared that information with competitors, the banks argued. Besides, the banks added, they don't benefit from keeping rates artificially low because that would reduce the amount they earn from borrowers. No decision has been made on the banks' request.

This scandal is far from over, but market experts predict that Libor's image eventually will recover.

But if investors' trust is to be restored, banks and regulators are going to have to make substantial changes to the way Libor is run.